Inferential Focus

Our "Change Wave" Investment Strategy

The "Change Wave" approach involves applying our early change detection to understand the impact of a change we discover on companies and sectors. By identifying change early, we learned, one can find appropriate investment vehicles and ride the wave upward, before the change’s impact becomes more apparent and other investors bid up prices. Conversely, identifying a Change Wave peak allows an investor to avoid the wave’s "wipe out" phase by exiting investments before price depreciation occurs and in selected situations, riding share prices down by shorting those companies.

Investment Portfolio Results

To demonstrate the potential of this strategy, we established our own portfolio in July 1998 and we invested for approximately three years, relying exclusively on the Change Wave strategy. Without the normal component of company analysis or the use of dividend reinvestment, we accomplished a 33-month capital gain of 51.7% for the portfolio, compared with a gain of 2.25% in the S&P 500, a gain of 4.77% in the Russell 2000 and a loss of 2.76% in the NASDAQ. As this is a model portfolio intended to represent the potential of investing directly from our Change Wave inferences, we used equal weighting of all positions - 1000 shares for each buy or short sale.

Performance Commentary

The tail end of what we defined as a "maniacal" period (see our Briefing "Maniacal Behavior") shows the beginnings of the unwinding of the technology mania – leading to the crash of the wave – and, therefore, we held an unusually large portion of short positions in the portfolio. Our timely use of short positions as we recognized the dangers inherent in the market entering the year 2000, which went against all conventional analysis and market sentiment, has provided particularly tangible evidence in support of investing off the Change Wave strategy. The following is a closer look at some of the changes we identified in their early stages and tried to exploit in the portfolio.

Our Intelligence: Oil

	In second quarter 1998, we began speaking to clients about the Saudis’ considerable efforts to create an alliance between OPEC and key oil-producing non-OPEC nations (which we termed NEWPEC). In November 1998, the new alliance appeared to be set.
	In Spring 1999, we wrote of the ensuing agreement among members to cut production, plus Riyadh’s implied threats to unleash its huge capacity if the production cuts were not followed. This set up optimal and, we inferred, real strong oil prices.
	As year 2000 was closing we pieced together a shift in alliances and therefore, suggested a plateau of oil prices at fairly high levels.

Our Actions

11/98	Opened long positions in oil services companies
12/00	Beefed up positions of companies already owned

Our Intelligence: Food Concerns

	Beginning in July 1998, we began to gather evidence of a growing skepticism about the safety of agricultural biotechnology. Companies like Monsanto and Aventis were pushing newly configured crops, however, they were being accused of causing damage to other crops and species in the environment.
	In November 1999, we pieced together concerns of environmentalists, labor and AIDS activists, cultural conservatives and many leaders of "have not" nations, and anticipated open protests at the upcoming WTO meeting in Seattle. We then watched as protests against among other things, (1) "Frankenfood," (2) "McDomination," and (3) "Bioinvasions" escalated beyond police control.
	As year 2000 drew to a close, we noticed heightened concerns rising around genetically modified foods, "mad cow disease" and an epidemic of obesity, especially among the young. Cautious consumers were looking for sources of "safe" food.

Our Actions

7/98	Opened long positions in organic food companies
11/99	Shorted companies involved in genetically modified food and food companies seeking to dominate overseas "local" markets.
12/00	Bought additional organic food companies. Continued shorts. Bought companies involved in the treatment of diabetes (consequence of obesity epidemic).

Our Intelligence: Computer Security Realities

	In March 1999, as industry pushed the proliferation of broadband connections, we recognized that "always on" access would create a dramatic shift in hacker capabilities and therefore in the potential for significant disruption.
	As these new broadband systems were starting to be deployed in third quarter 1999, we highlighted the opportunity inherent in investing in security providers and the dangers for system operators.
	The year 2000 saw a ramp-up in system breaches, including the surreptitious break-ins by governments and terrorist organizations as well as common criminals.

Our Actions

3/99	Bought Symantic, Checkpoint and Verisign
Q3 99	Doubled long positions and added three more companies

Our Intelligence: Broadband

	Following a history (since 1991) of the early identification of data compression technology and the emergence of the digital communications revolution, in June 1999 we drew a picture for clients of the transition to broadband Internet, which highlighted parts and components suppliers as well as companies initiating the convergence of digital services.
	By fall 1999, we picked up a major shift in the communications industry from an era of discrete technologies (single communications instrument) to distributed communications in which voice, data, video and Internet connections would travel at high speeds through various devices. The buildout of broadband capabilities was taking center stage in this transition. As companies committed to massive outlays of capital, we wondered if consumers would ultimately adopt the new technologies as fast as the investments required.
	In October 1999, we noted that industry behemoths in discrete technologies might have difficulty adapting. Next, we cited higher-than-anticipated costs of entry and less-than-anticipated consumer demand leading to lower-than-anticipated revenue.
	As the disappointments we noted unfolded throughout the year 2000, they produced a domino effect on the fortunes of: CLECs, telecommunications distributors, and the "gods" of computing technology, through Internet hardware, software and infrastructure companies. We were able to benefit from understanding this larger context and anticipating its implications on companies involved in each area.

Our Actions

6/99	Open long positions in major players
10/99	Closed our long positions. Sold short local and long-distance telecom operators
5/00	Sold short cable companies, optics and chip manufacturers
8/00	Added mobile handset producers to short portfolio

Our Intelligence: Japan’s Quandary

	A fundamental shift was afoot in Japan, one recognized neither by their domestic policy makers, nor Washington. While Japan’s cyclical downturn was evident to all, in February 1999 we described a dynamic of institutional restructuring and consumer reassessment that was also occurring. The negative effects of these secular changes upon efforts to stimulate the economy were not widely perceived. We noted the grave economic problems Japan faced – low consumer confidence, instability in the banking system and lack of corporate capital spending – and noted that these situations would impede a self-sustaining recovery.
	Yet, by August of 1999, we reasoned that businesses that responded to Japan’s new consumer attitudes could prosper, especially those offering greater perceived value.

Our Actions

8/99

Opened long positions in two Japanese consumer products companies and one bank

Our Intelligence: Hispanic Hoopla

In second quarter 1999, we began to recognize a fundamental shift in American demographics – the number of people of Hispanic origin in the U.S., at 30 million, was growing at a rate four times faster than that of the general population. The youth segment of this market was growing at the fastest clip. Clearly, Hispanic teens, we reasoned, have been and will be a growth market over the next several years. Companies that understand and cater to this market (or crossover market) should prosper.

Our Actions

8/99

Bought (long) Hispanic cable and television companies

Our Intelligence: The Game Changes and the "Gods" Tremble

In late 1999, we recognized that the technology sector made up 24 percent of the S&P 500, and that five companies – Microsoft, Intel, Cisco, Lucent, and Dell – made up roughly 11 percent of the index. In a time when the technology industry was undergoing a fundamental shift from offering discrete technologies to the development of distributed communications (see Broadband, above), each of these five "gods" was scrambling to become embedded in as many areas of the distributed network as possible. We inferred that these companies would not likely be as dominant in the new environment as they had been in their respective industries and, further, that the question of consumer adoption had not been addressed. The "gods" were ripe for a fall.

Our Actions

11/99

Sold short Microsoft, Intel, Cisco, Lucent and Dell

Our Intelligence: Internet Reassessment

	Throughout the year 1999, we developed a context for Internet business as one of a highly successful endeavor that had yet to make contact with reality.
	Entering the year, we noted that selling on the Internet was easy, but that creating a sustainable business was trickier and that e-commerce business lacked the infrastructure and support systems to sustain repeat business.
	Six months later, we added that the cost of capital was so low – indeed, nearly zero – that spending had become an addiction, free from nagging realities such as profits or return on investment. Advertising, seen as an aid to wean e-business from free money, was itself facing real world difficulties.
	By September of 1999, we suggested that realism was starting to creep into the process of evaluating Internet businesses, all to the Web’s detriment. We inferred that overcapacity, margin squeezes and nonexistent profits should lead to the break of enthrallment with anything.com, or stand-alone Internet enterprises.
	Entering the year 2000, we recognized that, especially in areas related to the Internet, behavior was looking more and more maniacal. We noted that while companies were trying to address their dependence on free capital, their methods were starting to show their inability to keep many businesses afloat.

Our Actions

1/00

Sold short four pure play Internet companies